Need to review 'last resort' methods

DIRECT TAX

In the past few years, an increasing number of fiscal authorities have taken action on transfer pricing . More countries are introducing tax laws governing it and/or enacting penalties for it's adjustments. In India, transfer pricing adjustments have increased at the rate of 100 per cent each year for the past three years and this has been a source of anxiety for multinational corporations. Not to forget, Revenue's underlying objective is to tax income on arms length principle to prevent shifting of profits from high tax to low tax jurisdiction.

In this background, a detailed guidance on transfer pricing issues has become imperative for Revenue and multinational enterprises alike. Of particular importance is a recent development in the global transfer pricing landscape "" the issue of a 'discussion draft on profit-based methods' by the Organisation for Economic Co-operation and Development (OECD).

Since the 1980's, OECD has been an indispensable force in shaping and setting standards for transfer pricing. In 1995, the OECD published 'Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations' which has served as guiding post for both member and non-member countries. As a part of its ongoing endeavour, OECD releases discussion drafts from time to time taking into consideration the needs of Revenue and business enterprises.

Late last month, the OECD released a draft that provides guidance on application of profit-based methods "" the Transactional Net Margin Method (TNMM) and the Profit Split Method (PSM). Internationally, five different methods are used for determining the fair transaction price "" the Comparable Uncontrolled Price (CUP) method, Resale Price Method (RPM), Cost Plus Method (CPM) and the profit-based methods comprising of TNMM and PSM. The same five methods are applicable in India. Whilst the first three methods focus on transaction prices, TNMM and PSM focus on determining and comparing the profitability from business operations as a whole.

PSM and TNMM have been regarded by the 1995 guidelines as methods of last resort "" to be used only in exceptional circumstances. A baffling large number of cases, in many countries, including India, have reported use of profit-based methods (particularly TNMM) for determining arm's length price. The draft guidelines now propose to dilute the hierarchy in the choice of methods and move closer to the 'most appropriate method' "" a rule already enshrined in Indian regulations. The 'most appropriate method' rule requires use of methodology that is best suited to the facts and circumstances of each case rather than any set hierarchy.

The guidance focuses on intricacies involved in application of profit-based methods to transactions involving intangibles. Pharmaceutical companies, in particular, stand to gain from such guidance, since they invariably own intangibles and involve participation of multiple entities in value generation. The GlaxoSmithKline settlement is a case in point (R&D was undertaken in the UK, while the marketing functions were performed in the US; speculation is rife that if the case was not settled, PSM may have been used to determine taxable profits). In our own backyard, in the recent Delhi Tribunal decision of Ranbaxy, TNMM was used as the 'most appropriate method' to benchmark prices for the Indian pharmaceutical giant.

Another controversial issue addressed by the guidelines is in respect of access to information. Ideally, tax administrators should have access to all information on cross-border transactions for compliance with laws. However, practically, this is not possible. For example, where the information required under a particular method is available with an overseas entity which is not under the control of the taxpayer. In such circumstances, the guidelines recommend a change in the method used such that comparability principles are not compromised for want of information.

Though, India is not an OECD member state, OECD guidelines play a supplementary role on issues where the Indian legislation is silent. An added reason for the importance of the new guidance is the widespread use of TNMM in India. The paucity of publicly available data leads to the application of TNMM in preference over other methods. Moreover, in contrast to other methods, comparability criteria for application of TNMM are less stringent. Recent jurisprudence in the case of Morgan Stanley, Aztec and Mentor Graphics has approved that the use of TNMM on the facts of respective cases. One hopes that the Revenue authorities willingly accept and respect the taxpayers' choice for using TNMM.

Jeffrey Owens, Director of OECD Centre for Tax Policy and Administration recently said "In the 1995 guidelines, the profit-based methods are the Cinderellas. Tolerated but not encouraged "" the methods of last resort. We need to review that." The discussion draft released by OECD is a manifestation of precisely such thinking. Though still in a draft form, given the reliance on OECD commentary and the emphasis on TNMM, the new guidance is bound to have wide ranging ramifications for Indian transfer pricing law and practice. I have no doubt that it would reduce an onerous obligation.

The author is Partner, BMR & Associates. Views expressed are personal.